Are We Qualified?

Richard Connor

WE SOLD OUR PRIMARY residence in the Philadelphia suburbs and moved to our New Jersey beach home in March 2021. The sale allowed Vicky and me to take advantage of what’s arguably the most valuable tax break available to everyday Americans: the capital-gains tax exclusion on the sale of a primary residence.

But while the tax break is valuable, it comes with strict and often-confusing rules—and those rules may work against us now that we’ve moved home yet again.

To understand our dilemma, you need to get a handle on Section 121 of the tax code, which allows homeowners to sidestep capital-gains taxes when they sell their personal residence. To qualify for the tax break, you have to meet the two-out-of-five rule, which states you must have owned and lived in the property for at least two of the past five years. In addition, you can’t have claimed the tax break for another home sale within the past two years. Individual taxpayers can exclude up to $250,000 in gains, while married taxpayers filing jointly have a $500,000 exemption.

Because you can use the exclusion every two years, you could potentially sell your home, purchase a new one, live there for two years, sell this new home and be eligible to shelter another large home-sale profit. The provision also allows folks with second homes to sell their primary home, move into their former vacation home, live there for two years and be eligible for a tax break.

Fine print. I recently, however, stumbled upon a little-known and confusing nuance. IRS Publication 523 lists exceptions that could affect a homeowner’s eligibility for the tax break. The nuance that could potentially affect us: If homeowners use a property as either a vacation home or as a rental property, that time is considered “non-qualified” use.

The 2008 tax law introduced a new requirement that limits the use of the home-sale tax break for periods of non-qualified ownership. For any sale after Dec. 31, 2008, the portion of any capital gain that’s allocated to a period of non-qualified use doesn’t benefit from the exclusion—and hence that part of the capital gain is taxable.

Confused? Suppose you and your spouse buy a vacation home, use it as a second home or as a rental property for two years, and then make it your primary residence for two years, before selling at the end of the fourth year. You’d be eligible to exclude 50% of any capital gain (two years of qualified use divided by four years of total ownership) up to the $500,000 maximum for a married couple filing jointly.

Let’s say the house cost $400,000 and was sold four years later for $800,000, leaving you with a $400,000 capital gain. Had it always been your primary residence, you’d have been eligible to exclude the entire $400,000 gain. But because you had two years of non-qualified use, $200,000 of the $400,000 capital gain is taxable income.

Adding to the confusion, the order in which your usage occurs matters greatly. Publication 523 lists exceptions to the non-qualified use rule. Among them: The qualified period includes “any portion of the 5-year period ending on the date of the sale or exchange after the last date you or your spouse (or former spouse) used the property as your main home.”

To understand what’s at stake, suppose you bought a home, lived in it for two years, rented it out for the next three years and then sold it. According to tax experts I’ve spoken to, you’d be eligible for a capital gains exclusion because you still met the two-out-of-five rule. Moreover, the three years when you rented the place out don’t count as non-qualified use because they’re subject to the exception mentioned above. This seems counterintuitive, but the IRS clarifies it in an FAQ.

What if you failed to sell the home within the three-year window that started after the last day that the home was your primary residence? In that case, you wouldn’t be eligible for even a partial exclusion—because you no longer used the place as your primary residence in two out of the past five years.

Our dilemma. That brings me to the issue facing my wife and me. Vicky and I bought our beach home in November 2019, initially using it as a rental property. We moved there permanently in March 2021. As of December 2023, we owned the home for 49 months. For the first 16 months, it was solely a vacation home, so that would be considered non-qualified use. Right now, the ratio of non-qualified use to total ownership is 33% (16 divided by 49). Let’s assume we sold the house on Jan. 1, 2024, for a $300,000 net profit. We would be liable for capital-gains taxes on $100,000 of the profit (0.33 x $300,000).

This came as quite a shock to me. I had assumed that, if we established residence for two years, we’d be eligible for the maximum exclusion. I’ve spoken with other owners in our shore community, and none of them was familiar with this tax-rule change. I also spoke with two experienced financial advisors who own second homes in our town. They, too, weren’t familiar with the rule change.

We purchased a new home in September 2023. We intend to make it our primary residence. We’re currently planning to hold on to the beach home and rent it out during the summer. Should we do that, we’ll need to make a crucial decision within the next three years—because, if we want the capital-gains tax break on the sale, we’d need to sell the home by Sept. 30, 2026, so we meet the two-out-of-five rule. 

At that juncture, we would have owned the house for 84 months. The initial 16 months of ownership, prior to making it our primary residence, are considered non-qualified use. Because of the exception referenced above, the period from the time we made the home our primary residence until the prospective sale date would all be considered qualified use. The upshot: Taking into account the 16 months of non-qualified usage, we’d be eligible for some 80% of the exclusion.

In other words, if the sale netted a $500,000 gain, we’d be eligible to exclude approximately $400,000, and be liable for capital gains taxes on the remaining $100,000. What if the market goes crazy and we saw a $1 million profit? In that case, $200,000 of the gain wouldn’t be eligible for the exclusion, but the remaining $800,000 would be. But the $800,000 portion is larger than the $500,000 maximum, so the net result would be that—out of the $1 million profit—we’d have a taxable $500,000 gain.

Another option. What if, in three years, we decide not to sell the beach house, and instead keep renting it? We may be eligible for another powerful income-tax strategy—a 1031 exchange. The purpose of a 1031 exchange is primarily to defer capital gains taxes on investment properties. In a 1031 exchange involving real estate, you trade one investment property for another, deferring any capital gain.

Seasoned real estate professionals in vacation communities use this frequently to “trade up” to more valuable properties. A 1031 exchange is complicated, with strict rules and timing requirements, so it’s prudent to consult a professional. One of the less attractive rules governing a 1031 exchange: To take advantage, you’re limited to a maximum 14 days of personal use in each year of ownership.

If we really want to ratchet up the complexity, Tax Revenue Procedure 2005-14 allows taxpayers to take advantage of both the Section 121 capital gains exclusion and the Section 1031 exchange provisions. Specifically, a homeowner can complete a 1031 exchange to defer any balance of capital gains above the 121 exclusion limit. In the example above, assuming a Sept. 30, 2026, sale, the $500,000 taxable gain could be invested in another property to defer the capital-gains tax.

One other nuance for vacation property owners: If you rent out your home at any time, you’ll face depreciation recapture when you sell. During the time you owned the rental property, this depreciation reduces both the property’s taxable income and the property’s cost basis, but that lower cost basis also increases the capital gain when the property is eventually sold. The portion of the gain allocated to the recaptured depreciation is taxed at a maximum federal rate of 25%, which is less than the maximum income-tax rate. Completing a 1031 exchange would defer this tax.

So, what will we do with our beach property? I’ve been asking myself whether, at age 66, I really want to take on the responsibility and complexity—including the tax complexity—of being a landlord. We’ve owned a beach town rental property before and it was a good experience. Our current plan: We’ll rent out the property for the next two summers, continue researching and assessing our options—and then make a final decision.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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